Financial Analysis a Structured Approach

Many users of financial analysis Buyers and sellers evaluate the durability of their suppliers or customers. The company analyzes an acquisition target. The CFO analyzes his company to identify strengths, areas for improvement and propose action plans. It compares the performance of the company with those of other companies in the same sector (determination of a sample of comparable companies). He presents accounts to administrators, bankers, etc.

All, however, use a similar approach, in different stages. It is essential to follow a common thread that makes it possible to reveal cause-and-effect links between the various stages, otherwise the analyst risks drowning in the mass of information.

Need of Structured Approach for Financial Analysis

The order in which the various stages of the financial analysis are located is a common thread that reveals cause and effect links:

• Growth in the business may be at the expense of profitability if the company increases its discounts in a policy of taking market share;
• Conversely, at times, sales growth leads to better absorption of fixed expenses and higher earnings proportionally than turnover;
• Business growth involves investing, at least in the industry, and has the effect of increasing the need for working capital;
• Improved profitability increases shareholders’ equity, decreases the need for borrowing and improves cash flow, etc

Analyze the Activity

The activity covers the evolution of turnover or production. It is the first step as it largely determines the next steps, profitability and financial equilibrium.

Analyzing the activity consists at least in interpreting the percentage of evolution of turnover. The internal analysis tries to decompose this percentage in terms of changes in prices; quantities sold or even a currency effect. He then strives to define on what type of product, customer, and market the company has grown? Has it developed growth relays; has it, on the contrary, activities in decline? For listed groups, IFRS requires, in the context of the segment reporting (IFRS 8), to break down several aggregates, including revenues from operating segments (geographic and / or business) when this segment is of particular importance (in particular, if its revenues represent at least 10% of the group’s income).

The analysis of the income model is an integral part of the analysis of the activity. Like the notion of economic model, this notion appeared with the first companies of the Internet. In fact, these companies have found original modes of generating revenue (paid referrals for Google, ads inserted in messages for Twitter or Facebook, fermium model for Wetransfer …). To enrich its revenue model, the company strives to develop multiple sources of revenue from the same asset or core competency, both to generate more revenue and reduce related risks to a single product or service

Example:

• BENETEAU has been producing high-end sailing and motor boats since 1884. During the economic crisis of 2008, the company developed a partnership with a luxury caravan manufacturer to make the interiors of these caravans quite similar to those of its caravans. Boats. One of his key skills is to know how to build high-end living space.

Many groups operating in a cyclical sector are developing a complementary service activity that generates a more stable turnover. Example:

• The computer services company CAP GEMINI makes the development of outsourcing a strategic axis. This activity, which consists in exploiting the IT service of its customers, is in fact a much more stable source of revenue than the development of computer systems that are largely dependent on the economic situation.

More broadly, business analysis often moves towards strategic analysis: what is the dynamics of the market on which the company is positioned, what is the company’s place in its market, what are the market segments?  Its strengths and weaknesses compared to its competitors, its chances of survival if a process of concentration is in place

Analyze Profitability or Wealth Creation

They are analyzed in two major effects, the chisel and absorption effects of fixed charges:

• The chisel effect is a favorable or unfavorable evolution of a selling price compared to a purchase cost. The advantage of the table of intermediate management balances (TSIG) is to clearly show this effect by the variation of the commercial margin rate for a distributor or the gross margin rate for an industrialist or service provider. These two margin rates are determined by comparing the selling price and the purchase cost of the commodities or commodities.
• When we talk about the effect of absorbing fixed costs in financial analysis, it is not a question of calculating a turnover, but more simply to note a better or less good absorption of fixed charges over the period. The analyst analyzes the evolution of predominantly fixed expense items such as other purchases, personnel costs, and amortization expense, expressed as a percentage of sales.

Examples of favorable fixed charge absorption effects:

• Turnover increases by 15% at constant strength;
• The company renegotiates its commercial lease by reducing the size of its premises.

Examples of effects absorption of unfavorable fixed charges:

• Turnover decreases without a corresponding decrease in operating expenses;
• The company has just opened a new sales office, generating additional fixed costs without the revenues from this new activity appearing (we will talk about the effect of latency because the increase in sales is expected in future periods).

Charges by nature or by function

The French accounting standards applicable to the individual accounts require a presentation of expenses by nature making it possible to use the table of interim management balances (TSIG) for which each intermediate result has an interest in the analysis of the profitability:

• Commercial margin (distribution) or gross (industry) rates make it possible to identify a chisel effect because they are calculated exclusively on purchase cost;
• The value-added rate compared to other companies in the same sector makes it possible to identify whether or not the firm outsources more than the industry average. This information is interesting insofar as the outsourcing of the estimated non-strategic activities can make the company more flexible;
• The gross operating profit rate is an indicator of operating cash flow and is not affected by calculated expenses, depreciation and provisions;
• The operating profit rate measures the profitability of the entire operation;
• Current earnings measure profitability excluding exceptional, non-renewable events.

The interest of the income statement with expenses by function (Anglo-Saxon approach) is to compare the cost of each function (production, commercial, administrative, R & D), expressed as a percentage of sales to other comparable companies. Thus, to note that the cost of the commercial function of my company represents 15% of the sales whereas it represents only 12% for my competitors leads me to wonder about the organization of this function.

IFRSs allow groups the flexibility to present expenses by nature or grouped by function. The SFAF (French company of financial analysts) has repeatedly expressed its preference, as an external analyst, for a presentation of the charges by nature to better identify the effects chisel and absorption of fixed charges.

Investments and Financing of the Period

If the analyst has the flow table, he can identify the investments in fixed assets and their method of financing as well as all the cash flows relative to the financing of the period (repayments of borrowings, dividend payments, etc.). . By making visible the flows of each period, the flow table provides an added value compared to the balance sheet which gives a static and cumulative vision. Remember that currently in France, this flow chart is only mandatory for consolidated accounts. However, it is possible to reconstruct the cash flows for a period from the tax schedules.

Conducting a financial analysis of a company consists of making a judgment on its economic performance and its financial situation, based on its accounting documents and knowledge of its environment. It is also about trying to extrapolate the analysis from the past to the future.

Analysis of Financial Balances

These financial balances are determined from the balance sheet, which is based on a balance between capital employed and financial resources.

Anglo-Saxons analyze the liquidity balance sheet that distinguishes “disbursable” debts to more than one year, from those that are “disbursable” to less than one year, regardless of the nature, financial or operating. It shows working capital liquidity.

The functional assessment reveals a relation between three aggregates:

Working Capital (FR) – Working Capital Requirement (WCR) = Net Cash (TN)

This presentation of the balance sheet was designed by the financial analysts of the Banque de France after the first oil shock in the mid-1970s and the ensuing wave of corporate failures. Their goal was to detect and diagnose cash crises.

FR Analysis

After examining the evolution of working capital itself, the analyst focuses on its various components:

• Has the company invested in fixed assets? What is the nature of these investments, material or financial? ;
• How did she finance her investments?
• Is it not too much indebted to MLT (ratio composition of permanent capital); is it a priori able to repay its loans to MLT (dynamic repayment capacity ratio)?
• Does it have sufficient shareholders ‘contributions (shareholders’ equity or current accounts of shareholders blocked or not) sufficient (financial autonomy ratio)?

BFR Analysis

The WCR is the financing requirement of the operating cycle; the CFO has a dual concern for him:

• Ensure that current operating assets are well managed, notably thanks to actions taken by the operational staff on inventories, outstanding, trade receivables, customer deposits, etc.
• Secure it’s financing.

The analysis focuses first on the evolution of the BFR expressed in amount and then expressed in days of sales HT. Analyzing the WCR in terms of time makes it possible to compare companies of different sizes and to refer to a sector average. The BFR being the result of different items, it is finally necessary to examine the different deadlines: stocks, customers, suppliers, deposit rate.

• Analysis of the Net Cash (TN)

Excess or borrower at CT, the cash position ensures equality between all jobs and resources. Any business failure is due to a deterioration of the cash flow whose cause must be found to be able to solve or anticipate it. Since the net cash position is only the result of the FR and the WCR, its evolution is only interpreted by the variation of the upstream aggregates, the FR or the BFR.

Var of FR – Var of BFR = Var of TN

The diagram below shows us that ratio analysis does not constitute a “separate” analysis but that it fits into the analysis of balances and financial structure. Thus, structural ratios answer questions that the analyst asks about permanent capital.

Analyze the Economic and Financial Profitability

Profitability ratios are not analyzed systematically. Thus, a credit manager analyzing the short-term solvency of a client is generally limited to the analysis of the profitability, the WCR and the cash position. Recall that the term “profitability” refers to the relationship between a result and invested capital.

Economic profitability relates to capital employed, fixed assets and BFR. The diagram below indicates that this ratio assesses the overall economic performance of an activity.

• The Financial Profitability Ratio

The financial profitability ratio is equal to the ratio between the net profit and the accounting equity. It evaluates the profitability of shareholders’ equity entrusted to the company. Shareholders’ profitability would be evaluated on the purchase price of the securities, which is often different from the accounting equity. Increasing profitability on equity is an objective for investors.

The diagram below shows that good economic profitability contributes not only to improving the return on equity, but also to strengthening the financial structure (equity ratio / financial debt). A high result helps to increase equity while the control of fixed assets and WCR reduces the need for external financing.

These ratios, however, are often imperfect measures because the return on an investment is measured by its cash flow over its life, which is a multi-year horizon.

The Qualities of the Analyst

• Rigor in the process

It is by following the structured approach that we have taken that the analyst will avoid drowning in the mass of encrypted data and may reveal cause-and-effect links between the different stages.

• Analytical mind

Key points need to be highlighted at each stage without getting drowned in detail. Imagine that you prepare the presentation of the financial situation of the company before the board of directors; you will highlight three or four key points at each stage.

• Know how to speak numbers

Throughout the process, the analyst makes the link between his knowledge of the company and the sector of activity and the figures. He highlights the characteristic figures: “Behind every figure, there is a story to be discovered”. For example, a financial independence ratio (equity / liability) of 50% may reflect the cautious financial policy of a family shareholder, the need to finance large amounts of production…

• Extrapolate from the past to the future

What are the prospects for the evolution of the market in which the company is located? Has the company developed growth drivers?

Are major investments planned in the next two years? The structural ratios can be degraded following investments that have just been made and improve mechanically in the following years thanks to repayments.

Did the bankers tell you that they would accompany you if you solicited them to finance an investment or increase a line of credit to CT?

Will shareholders be able to make new capital contributions or current accounts if necessary? If so, do they agree to share control by bringing in new investors?